Expanding Uses For NFTs Lead To New Legal Frontiers – Fin Tech – United States

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Expanding Uses For NFTs Lead To New Legal Frontiers – Fin Tech – United States


Introduction – Non-Fungible Tokens (NFTs)

Despite the ongoing “Crypto Winter,” the use of NFTs
continues to rise. NFTs are associated most often with pictures,
videos, and music, but developers have been finding many new and
useful applications for them.1As the applications for
NFTs grow, the legal considerations expand, particularly when the
NFTs are used in ways that touch on multiple areas of the law.
Analyzing the potential legal implications for an NFT-based project
requires an understanding of the law and a firm grasp of how the
underlying technology is being used in this evolving space.

We created this article to provide an overview of legal issues
surrounding NFTs and their many applications. This article
highlights possible issues under U.S. law for this expanding and
evolving technology. First, we discuss different use cases for
NFTs, including some that are now common and some that are new.
Notably, the categorization is artificial, as an NFT can be made to
address use cases from multiple categories. Using these categories
should still provide a helpful overview. For each of these
categories, we discuss possible legal considerations that may come
into play. These concerns are multifaceted and can run the gamut
from intellectual property, privacy, securities and contracts to
know your customer (KYC) procedures, anti-money laundering (AML)
compliance, and corporate governance laws. Second, we discuss some
of the technical innovations for NFTs, some of which have yet to
see widespread adoption but can open up new use cases for the
technology. In all cases, obtaining knowledgeable legal
representation to identify potential legal issues is essential when
developing NFT technologies or incorporating NFTs into existing
projects.

NFTs by Use Case – Potential Legal Considerations

NFTs for Creative Works

Most people think of NFTs as signifying rights in a creative
work, which is understandable, as this is currently the most
popular use case. In this instance, the NFTs are associated with a
particular work, be it an image, video, music, or writing. For
example, an NFT could be linked to the image of a particular
cartoon ape. In another example, an NFT can signify some ownership
rights in a song or album.

The most typical legal issues with these NFTs involve contract
law and IP licensing in copyrights and trademarks. This is because
the NFT is purchased, and the art it is associated with may also be
covered by separate rights for the copyright. Any rights to the
copyrighted art must be sold or explicitly licensed to the NFT
purchaser to be properly conveyed. For example, there may be issues
on what rights are provided to the person who holds the NFT,
including whether they can commercially exploit the art and, if so,
what limitations are placed on this usage.

A common consideration is also how to notify purchasers of their
rights in the underlying artwork when they purchase the NFT. This
can get tricky, particularly when the NFTs are allowed to be sold
on secondary markets that may or may not provide explicit notice of
the ownership terms when making a purchase. Making the purchaser
aware of their rights at the time of sale is important because,
depending on the particular NFT, the rights may vary widely from
one purchase to another.

Failure to notify a purchaser of what rights they are obtaining
can lead to confusion because purchasers of NFTs often assume they
are buying full ownership the actual artwork and can do what they
want with them, such as exploit the artwork commercially. However,
NFTs associated with video and music often do not provide any
rights to the owner to commercially exploit the content. For
example, a professional sports league or organization that mints
NFTs associated with video clips is unlikely to give the owner of
the NFT the right to exploit that video commercially. Providing
clear license terms to the purchaser is a good policy to avoid
customer confusion. Similarly, providing these terms in a way that
remains easily accessible as the NFT is transferred requires
consideration because it will vary based on how the NFT can be
transferred and what rights are provided.

A new and rapidly expanding consideration is when an NFT is
generated in whole or part by artificial intelligence (AI).
Multiple systems have been developed to generate art and written
work using AI. In this case, there may even be an open question of
whether a copyright in the work even exists, but this is a very
fact-specific inquiry based on particular circumstances. There may
also be the layering of issues, such as when AI is fed a
copyrighted piece or pieces of work to generate new works that
alter, expand or build upon the work it was fed.

Another consideration that can arise under some uses for NFTs is
if they are securities, meaning that they would be regulated by the
Securities and Exchange Commission (SEC) if sold to customers in
the U.S. While it may seem hard to believe that purchasing a
cartoon picture could be considered the same as purchasing a share
of common stock, the SEChas at least been indicatingthat this is
possible. For example, if an NFT is structured so that the owner
receives rewards or royalties for the use of the digital art
(e.g.,if it is a song being played on a streaming
service), then securities implications may come into play.
Additionally, promises of those issuing the NFTs to provide
privileges as the community grows, say to attend exclusive events,
may raise securities-related issues.

The above examples are just some of the issues that may arise,
but others including KYC procedures, AML compliance, and tax
compliance may also be at issue depending on how the particular
NFT, and any marketplace for that NFT, are implemented.

NFTs for Video Games and Metaverse

Developers are also quickly expanding theuse of NFTs in video gamesand virtual worlds
(the “Metaverse”). For example, an NFT could be
associated with having the ability to unlock the use of a
particular character in a game. Or it could be used as part of an
inventory system to identify the character’s equipment, where a
particular set of armor is associated with a corresponding NFT.
NFTs can also be sold in random “packs” similar to
trading cards. In these cases, a user can purchase a pack of cards
and randomly be allocated a pack unlocking certain players. Instead
of these cards only being collectible pieces of cardboard, they
allow the player to use them in games similar to fantasy sports
matchups, which may include prizes. For the virtual worlds of the
“metaverse,” an NFT can be associated with ownership of a
particularplot of virtual landwithin that particular
world. The purchaser can then develop their plot of virtual land to
advertise a business or simply for their enjoyment.

On one level, there is nothing new with games using some
mechanism togate accessto particular characters or items.
However, NFTs provide a greater feeling of ownership to players,
because these items can be associated more permanently with that
character or item. Additionally, it may allow NFTs to be traded
directly among players on a blockchain. To many, having the content
represented on a blockchain makes it more desirable because it adds
a sense of permanence to the experience.

These NFTs can have many of the same legal issues described
above for digital artwork. Many include digital art as part of the
NFT – think of a picture of the set of armor for your character.
However, additional issues can arise if more features are added to
these items. For example, securities considerations (and the SEC)
may come into play if the proceeds from the sale of these types of
NFTs are used to build the underlying game that they are used in.
While having a sword your character uses in the videogame be deemed
a security seems a bit farfetched, the SEC has generally taken an
expansive view on crypto tokens being securities if the sale
proceedsare used to build functionality. In
particular, they have noted that selling tokens for the development
of an ecosystem could show that they are being used as an
investment into this ecosystem.

In the case of NFTs sold as packs of cards, they may combine
three incredibly popular activities: NFT collectibles, fantasy
sports and gambling. In addition to the legal considerations
discussed above, this type of use that provides prizes must
consider gambling and related contest and sweepstake laws, which
are often regulated differently state by state. These factors must
be considered specific to what is provided with the NFT at issue
and the jurisdiction(s) over the purchase.

NFTs as Representing Real-World Assets

NFTs have also become linked to real-world physical assets and
signify ownership or some right associated with that asset. In one
example, NFTs have been proposed as a superior way torecord ownership in real estate. Instead of
keeping physical records on real property in a city hall archive as
the definitive record of ownership, this information could be
recorded on the blockchain. In this manner, it could be easily
searched and verified. However, this type of ownership record does
not need to be limited to real estate and has been proposed for
other real-world assets, typically those of high value, such as
paintings, vintage cars, watches, andgems, which benefit from having a trusted
chain of title and trustworthiness of ownership. While the above
are some examples, there isno limit on what type of physical assetscould
be matched to NFTs. These NFTs also can have particular utility for
recording high-value assets in a supply chain, allowing the system
user to certify the assets’ origin and confirm that they were
legally and ethically sourced. Furthermore, with the advent ofmultiple inexpensive Layer 1 and 2
blockchains
, the cost-benefit analysis for these systems has
increased drastically.

The ability to transfer ownership rights in real-world physical
assets already has an extensive legal background. These include
issues related to contract law, real estate law, tax compliance,
the Uniform Commercial Code (UCC), etc. For example, real estate
has its own unique body of law governing, for example, how to
record and transfer property. Any usage of NFTs for real property
would be required to navigate these laws in addition to those
generally governing NFTs. Even the sale of other objects can
require knowledge of the law under the UCC, which may cover some
transactions. All of these transfers may also trigger specific tax
and recording requirements that should be considered at both the
federal and state levels.

NFTs as a Form of Identity

NFTs have also been proposed as a way of providing identity, and
have been discussed regarding the allowance of building a“DeSoc” or Decentralized Society.
There are various proposals for how NFTs can provide a form of
identity for users and thereby add “reputation” to
blockchain applications.

To transact on the blockchain, no one needs to know who you are
in real life. However, situations may require where a user may want
to build a reputation that is proven and validated by its recording
on a blockchain. You can even build up a reputation in a
pseudo-anonymous fashion. This way, you can transact on blockchains
without revealing your real-world identity (i.e.,
“doxxing” yourself, in web3 parlance), but also without
abandoning the ability to build goodwill and a positive reputation
among the community.

Much of the transactions on blockchains are possible without
establishing identity because they are typically meant to be
“trustless.” Transactions can be run by smart contracts
that both parties can verify before entering into a transaction.
For example, if two parties are entering a DeFi loan, a smart
contract could determine when the first party deposits the required
collateral, and only then release what is being loaned to them,
thereby obviating the need to trust the person you are interacting
with. Instead, you trust the publicly verifiable smart
contract.

However, there are limits to what can be done without having a
transaction tied to a particular real-life person or at least some
measure of a user’s reputation. For example, the above scenario
of a DeFi loan is based on what can be locked in as collateral on
the blockchain. It does not consider other off-chain assets that
may support the borrower’s creditworthiness or that the
borrower had taken out loans before and always paid them back. Some
would argue that limiting the decision to properties that can be
verified on-chain is an important feature. Still, it does limit
what types of agreements can be entered.

In other instances, users should be verified for anti-money
laundering (AML) purposes. Instituting an AML procedure often
requires an individual process utilizing “off-chain”
information. It may be better to allow for a standard verification
of identity (KYC) that can be completed on-chain. These types of
provable identities can be helpful in systems meant to grant access
to private information, such as medical records, or where a
specific person must be identified for a particular right, for
example, the ability to vote in an election.

However, there are several different issues with implementing
identity NFTs. First, there is the concern many web3 natives have
with publicly revealing their real-life identity and
“doxxing” themselves. However, using these types of NFT
for specific purposes may require a KYC procedure to assign the
NFT. Therefore, those running the systems may also need to consider
privacy laws based on how they use that real-world identity. In
conjunction with privacy laws, regulations related to the necessary
level of security are applied to this type of information. Finally,
if used in the context of securing a loan, there are banking laws
and regulations that may need to be navigated.

NFTs as a Certification or Resume

Numerous entities are now offering NFTs that act as a
“certificate” for completing a course or other
certification program. You can build up a blockchain-based history
proving your completion and knowledge of different topics. In a
typical scenario, you take an online course with a test at the end,
where an NFT is granted to show completion of the course. These are
already being used by several web3-oriented companies that offer
training (mainly in web3 technologies) and provide an NFT upon
completion.

In other situations, NFTs can be granted for other
professional-based tasks that either prove experience or completion
of a course. For example, a freelancer could receive an NFT from an
employer establishing that they have adequately completed a project
for them. This shows the certificate’s authenticity in a way
that is “web3” in nature. This could serve as a digital
resume that prospective employers could review.

The advantage of this process is easy to see, as a blockchain is
immutable and verifiable, so it would be difficult, if not
impossible, to forge a certificate. Someone seeking employment
could submit an address showing their different certifications and
records of task completions. Furthermore, this can still be
pseudo-anonymous, where the parties do not need to know the
person’s real-life identity to verify credentials or check
references, as the information is all recorded on the
blockchain.

Again, there are likely to be privacy issues associated with
these, as the certificate is intended to be used only by a single
person. It would make little sense to allow one person to sell
their NFT showing they completed a course to another person who has
not completed it. As such, there often need to be some constraints
to limit the use of the NFT to a particular person.

The use of NFTs as a form of certification overlaps with many of
the same issues relevant to NFTs used for identity, including
privacy and KYC issues. They may require special provisions in
terms of use for the recipient and other statements limiting
liability of the issuer, including in cases where certification was
used by someone who had not earned it.

NFTs as Governance Tokens

NFTs can also be used to establish voting rights in the
governance of an entity. One example is seen in the ability to vote
in a decentralized autonomous organization (DAO) or a similar
organization based in the digital realm. While many DAOs can use
standard fungible tokens for governance, there is increasingusage of NFTsassociated with voting rights. In
particular, if the structure of the DAO is “one person, one
vote,” this may be represented by an NFT identifying the
voting right of the specific person. These NFTs can also
demonstrate membership in the DAO or work completed for the DAO.
Furthermore, a new NFT can be used for membership each year,
providing another way to identify those with a long-term commitment
to the DAO.

Of course, the rights provided for those holding the NFT may
need to be identified in the governing terms of the DAO.
Furthermore, if the NFT is supplied with the possibility of it
gaining in value or as a source of revenue, this can impact
securities regulation. The use of NFTs can affect the form of the
legal entity (if any) that the DAO takes and can require knowledge
to address any corporate governance or tax laws adequately. KYC and
privacy issues may also arise if the governance NFTs are structured
to avoid a “Sybil attack,” where one person sets up
multiple accounts to get more than their fair share of votes.
Finally, while not specifically related to NFTs, DAOs have theirown legalissues to consider, including thoserelated to whether their members are liable for
their actions.

NFTs for an Experience

NFTs have also been used to replace tickets for different
events. In this case, the NFT would be assigned to a wallet and
have a single use for the particular event. Given the tamper
resistance of a blockchain, this would be a way to avoid forgeries.
Furthermore, the issuers have ways to place restrictions on the
ticket transfer. For example, collecting a fee every time the
ticket is transferred between wallets. This would allow artists and
venues to recoup some of the value when tickets are resold at a
much higher value.

This type of NFT can also be used as proof that the person was
present for a particular event. The person with the NFT ticket
could keep it in their wallet as a keepsake for the event,
collecting and showing them off to others if they care to do so.
Similarly, NFTs can be issued to commemorate an event. For example,
the Super Bowl issuedcommemorative NFTsfor those who attended. This
type of commemorative NFT can be used as a status symbol or a
keepsake for those who attended the event.

This type of use can run into legal issues related to the terms
of their use, as the NFT can be used as part of a contract. It is
also important to lay out the terms for the NFT so that there is no
customer confusion about what they are purchasing. Granting this
type of NFT in a graphical form similar to a sports or concert
ticket may also lead to questions on when and where the owner of
the NFT can display the NFT, as the NFT may include other
trademarks or copyrights.

NFTs as a License or Subscription to a Resource

NFTs have also been explored as a means of recording the right
to a license or a subscription. For example, a particular NFT could
be an on-chain method to show that the holder has the right to
access a specific resource in the cloud. Enforcing licenses in the
software context has been an issue almost since the beginning of
consumer software. Using NFTs for licensing specific technologies
aim to improve the ability to implement these licenses. In
particular, using an NFT as a license allows for enhanced
functionality for protecting against pirated software or allowing
the license to be transferred or sold to another without
encountering the“double spend” problem,where two
people try to use the same license. Similarly, NFTs can be used in
a subscription model to record the status of a subscription to a
particular service.

Unsurprisingly, using NFTs to represent a license often gives
rise to contract issues requiring a good grasp of how the NFT may
be used – including both the intended and unintended uses.
Furthermore, one of the usual advantages of NFTs, and crypto in
general, is the ability to remain pseudo-anonymous. However, if an
NFT is granting a license, the seller may be required to do KYC
checks to ensure the purchaser is using the license for its
intended purpose and that they are not a sanctioned country or
entity. As such, the use of NFTs in this manner requires the
analysis and balancing of the multiple intersections of the
evolving laws and technical applications.

NFTs for Naming Systems

Another recent application of NFTs is to use them in a way
similar to how the Domain Name Service (DNS) is used. The most
prevalent system for this is called the “Ethereum Name
System
” (ENS), but it is far from the only system of this
type. For the ENS, the top-level domain is owned and controlled by
smart contracts. Users can register a name that ends in
“.eth” based on the ERC721 non-fungible token contract
and the namecan be transferred like other NFTs. Like the
DNS, the ENS can map human-readable names (e.g., kriskastens.eth)
to machine-readable identifiers like Ethereum addresses.

These domains have many of the same issues seen with DNS,
specifically where someone grabs a trademarked name and either
attempts to profit off it or hold it as ransom from the actual
owner. This has led totakedown requestsrelated to selling these
names on marketplaces. However, since these registrations are
blockchain-based, they can be difficult (or impossible) to rescind
from those who purchased them after they are assigned.

Expanding NFT Functionality

Our analysis above relates to the use case for NFTs. However,
another way to look at NFTs is based on their technical operation
independent of their use. At its most basic, an NFT is unique data
recorded on a blockchain that defines its function. In the section
below, we discuss some of the technologies that NFTs use, including
newly developed technologies that expand their utility. This is a
constantly growing and changing space, so this section is only
intended to provide some examples.

Blockchain-Contained NFTs

Certain NFTs record all their information on the blockchain.
This case is usually when the amount of data to be recorded is
small enough that it is not cost-prohibitive to store it “on
the chain.” This may be possible with numerous use cases, such
as NFTs representing membership or completion of a course, but is
less common with NFTs representing a creative work, which typically
requires more space to store. Some estimate that
only 9% of NFTs
store all their data on the blockchain because
of the cost of storing data. While this type of storage is
advantageous to prevent the linked data from disappearing, they do
have the issue of exposing the data to the world, as most
blockchains are public. Furthermore, for someone who makes these
types of NFTs, if there is something wrong with them, e.g., they
infringe a trademark or copyright, there may be no way to stop
their usage once they are on the chain.

NFT as a Link to External Data

The majority of NFTs act as a link or pointer to other data that
is stored externally to the blockchain. So instead of keeping
everything on the blockchain, they use a pointer from the NFT to a
file stored off the blockchain. One common location was something
called the “Interplanetary File System” (or
“IPFS”), 2but it can conceivably include any
location where the party making the NFT wants to store the data.
Depending on what is being held in the linked data, this can impact
privacy issues if it includes identifying or personal information
and security issues, such as if the data is stored in a secure or
encrypted manner. Furthermore, there may be issues with specifying
how long the data that the NFT is linked to is stored. For example,
while the NFT itself will be stored on the blockchain for as long
as that particular chain exists, if the company hosting the image
disappears, the actual data may disappear, leaving the NFT as a
pointer to nothing.

Soulbound NFTs

A so-called “soulbound” tokenis intended to be specific
to a particular person (or address) and will not be transferred.
This way, these tokens, including NFTs, cannot be sold to or shared
with others. The use of this mechanism is immediately
understandable given some of the uses discussed above. For example,
an NFT signifying identity or that a person has completed an
educational course should not be transferrable to others who have
not completed the course. Additionally, using soulbound tokens for
governance rights in an entity would also be beneficial, as making
voting rights that are not transferable can be helpful in many
cases – for example to help prevent sybil attacks.

The fact that soulbound tokens are meant only to be assigned
once makes it even more important to specify the terms of their use
to avoid confusion. Any mistakes or misunderstandings may be more
difficult to correct after the fact. Additionally, the use of
soulbound tokens for governance requires that the entity using them
understands the permissible governance structures and ensures that
their usage is explained to the extent necessary under corporate
governance documents.

Fractional NFTs

With the high cost of certain blue-chip NFTs, it can be
cost-prohibitive for certain people to own one outright. However,
to solve this, some have devised schemes tofractionalizeortokenizethe ownership of the NFT to demonstrate
partial ownership of the NFT, and in this manner, multiple people
could share ownership in an NFT.

There are some unique legal issues associated with the
fractional ownership of NFTs. While NFTs typically escape scrutiny
from the SEC because their primary utility is as art or a
collectible, that ismore difficultto claim when you only own a
fraction of the NFT. For these, it may be more closely aligned with
an investment in the NFT, assuming that it will rise in value and
the fraction can be sold at a profit. The use of fractional
ownership in an NFT is something that the SEC has hinted may be
considered a security. As such, if fractionalization of an NFT is
used in a project, then its structure should be carefully
considered.

Semi-Fungible Tokens (SFTs)

SFTs are generally understood to be tokens that have someproperties related to both fungible and
non-fungible properties
. In one use case example, SFTs start
out as fungible tokens and then, based on some event, are converted
into NFTs. This can occur in a video game when the fungible
currency inside the game can be converted into NFTs for weapons or
other items. As fungible tokens can be already transferred to
purchase NFTs (think buying NFTs for Ether), it may not be
immediately apparent what the benefit SFTs offer. However, they are
beneficial on the high-cost Ethereum blockchain, where they have
significant cost savings in the conversation because ofERC-1155, a standard that some have argued can
allow up to 90% savings.

SFTs may include novel legal issues with respect to whether they
are viewed as securities, as they have properties of both fungible
and non-fungible tokens. In this case, it will be important to
consider the specifics of the particular SFT and how it is
used.

Dynamic NFTs (dNFT)

dNFTs are NFTs designedto change over time according to how the smart
contract governing them was programmed
. The fact that dNFTs
canchange over time based on external
conditions
allows them additional flexibility. For example, if
an NFT is used to represent a car, it may be useful to update the
NFT with information showing that the car was serviced in a timely
manner or to reflect that it was certified to meet emission
standards. The NFT can also be used to describe real-world assets
that are tracked in a supply chain. In another example, a dNFT ofan athlete may change over a season or their
career based on their performance
.

Depending on their use, dNFTs will have the same potential legal
issues as normal NFTs but with a higher level of complexity because
of their ability to change. They will require a technical
understanding of how the dNFTs will operate. For example, any
contracts that govern dNFTs will need to consider how they are
intended to act, as well as addressing when they operate in an
unintended manner. Being able to understand both the intended and
potential unintended operation of the dNFT is important, as it is
sometimes impossible, but always suboptimal, to change a smart
contract after deployment.

Conclusion

NFTs are an exciting technology with expanding use cases.
However, as their uses expand, they will continue to intersect with
new and evolving areas of law. Dealing with these novel legal
issues will require understanding both the ever-changing legal
landscape of blockchain technologies and how it intersects with the
expanding technical applications of NFTs.

Footnotes

1 The term NFT has taken on a perceived negative
connotation in some circles, particularly after the NFT craze of
2021. As such, NFTs are being referred to as “digital
collectibles” and other terms. We will use NFT here because it
is still the most comprehensive term to describe this type of
token.

2 This is a distributed and open file system that can be
used to store the actual artwork linked with the NFT.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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